Thousands of entrepreneurs, investors hit with surprise tax

Entrepreneurs and angel investors across California are getting a surprise: a retroactive Qualified Small Business tax bill in the mail this week.

The state’s Franchise Tax Board wants to collect an estimated $128 million from 2,500 entrepreneurs, after a judge last year ruled California’s nearly 20-year-old Qualified Small Business tax incentive program was unconstitutional.

In response, the Franchise Tax Board is asking people who benefitted from the incentive between 2008 and 2012 to pay back that money to the state with interest. Roughly 500 entrepreneurs each year take advantage of the Qualified Small Business incentive, holding onto an average of $30 million per year, said Franchise Tax Board spokeswoman Denise Azimi.

The group of affected entrepreneurs is small but vocal. Most have sold at least one startup, and used the incentive to cut their state bill on taxable stock gains in half. Others used the incentive to reinvest in their next small business.

High-profile entrepreneur Jim Fowler is one of the 2,500 people getting surprise tax bills. In 2010, he sold Jigsaw to Salesforce.com for $125 million. He has since reinvested some of that money in his next startup, San Mateo-based InfoArmy.

Fowler and three other entrepreneurs banded together this month to form California Business Defense. The group hired a Washington D.C. lobbyist, and has begun pressing California lawmakers to reverse the Tax Board’s action.

“The most important pressing issue is wiping out the retroactive nature of this because it’s so insane on so many levels,” California Business Defense member Brian Overstreet said.

The group has already recruited two lawmakers, State Sen. Ted Lieu, D-Torrance, and Assemblyman Jeff Gorrell, R-Camarillo, to lobby the Franchise Tax Board. In a letter published this week, Lieu urged the Franchise Tax Board to apply the Qualified Small Business tax going forward, and not retroactively penalize those who benefitted from it in the past.

“California is not a Banana Republic,” Lieu wrote. “California government should not punish innocent, law-abiding taxpayers retroactively just because it may have the power to do so.”

How the state got here

In 1993, California approved the Qualified Small Business tax incentive, designed to spur small business investments in the state.

The incentive allowed small business investors who sold their long-term stock at a profit to keep half of those profits on their state income taxes, for example, paying 4.5 percent instead of 9 percent.

In other cases, the state allowed small business investors to take all the profits from the sale and reinvest them in another qualified, California business. In August, a state judge ruled the program was unconstitutional, because it put out-of-state businesses at a disadvantage.

Eye-rolling online

The $128 million the Franchise Tax Board wants from 2,500 taxpayers works out to roughly $50,000 per person.

Online, some in Silicon Valley characterized the controversy as a tempest in a teacup, only affecting a group that isn’t exactly hurting for money.

“Just closed a loophole that the wealthy were not entitled to in the first place,” one person wrote on a tech blog. “Sorry, not feeling it. Pay up!”

Not so fast, Overstreet says. He’s gotten calls and emails this month from early-stage employees of startups who sold their shares back in 2008 and are now facing retroactive tax bills of $5,000 to $10,000. These employees aren’t mega-rich and simply can’t afford to pay the bill, he said.

“Think of the number of people who started businesses over the past five years,” Overstreet said. “Of the ones who succeeded, grown and successfully exited… everybody who’s made their way up this ladder are being hit with this tax. If you’ve done everything right and you’re one of the lucky few who’ve exited, you’re being penalized.”

The people getting state notices under the Qualified Small Business tax rollback have 60 days to dispute the notice’s estimated total, the Tax Board’s Azimi said. Checks are due in the mail shortly thereafter.

Want more information? The Tax Board has a set of FAQs, here, and learn more about the California Business Defense here.